November 19, 2007

Yield spread premium abuse by mortgage brokers is collecting a rebate from the lender for delivering a high-rate loan, without the knowledge of the borrower. The way to eliminate the abuse while retaining rebates, which are valuable to many borrowers, is to enact a rule that all rebates must be credited to borrowers, who would then have to authorize the payment to brokers. To maintain a level playing field between brokers and loan officers employed by lenders, there should also be a rule that prohibits overages -- charging the borrower a price above the price posted by the lender.

The Mortgage Reform and Anti-Predatory Lending Act of 2007(HR 3915) is now winding its way through Congress. According to the bill’s sponsor, Rep. Barney Frank, D-Mass, one of its important objectives is to prevent mortgage brokers from steering borrowers into higher-cost loans.

Brokers steer borrowers into high-cost loans so they can collect a rebate from the lender. A rebate retained by the broker is called a “yield spread premium”, or YSP. Rebates pocketed by brokers without the knowledge of borrowers constitute YSP abuse.

How YSP Abuse Arises

Lenders pay rebates on high-rate loans, and charge points on low-rate loans. Points are upfront payments to, and rebates are upfront payments from, the lender. On November 7, 2007, wholesale lenders quoted the following prices to brokers for a 30-year fixed-rate mortgage: 6% at zero points, 5.75% at 1.25 points, 6.25% at 1 point rebate and 6.50% at 2 points rebate. This means that the lender wants to be paid 1.25% of the loan amount for 5.75% loans, and will pay 1% or 2% rebates for 6.25% and 6.5% loans, respectively. For more, see Can Mortgage Points Be Negative?

Brokers who operate with full disclosure, including Upfront Mortgage Brokers, tell the borrower their fee, and allow the borrower to select the rate/point combination they prefer. See What Is an Upfront Mortgage Broker?

If the broker’s fee is 1 point, for example, the borrower who wants the 5.75% loan will pay 2.25 points – 1.25 to the lender and 1 to the broker. If the borrower selects the 6.25% loan, the broker’s fee will be covered by the lender rebate.

Indeed, a borrower strapped for cash might select the 6.50%, or go even higher to get a rebate large enough to cover all miscellaneous lender and third party charges. “No-cost” loans are created using the lender rebates offered on high-rate loans. See No-Cost Mortgages. Legislators don’t want to enact any rules that will deprive borrowers of this valuable option.

Most brokers don’t practice full disclosure because they can make more money by pricing opportunistically. Most often, they quote the highest rate they think the borrower will accept, and pocket the rebate, usually without the borrower’s knowledge. The borrower may discover it after the fact in closing documents, if they know where to look.

Disclosure Is Not an Adequate Remedy

The challenge to legislators is to eliminate opportunistic pricing without eliminating rebates. The obvious remedy appears to be a disclosure requirement -- mandate that brokers disclose their fees upfront, as Upfront Mortgages Brokers now do voluntarily.

For a disclosure requirement to be useful, however, borrowers need information about broker fees at or before their first contact with the broker, which is earlier than any enforceable rule can provide it. Incorporating the fee in the Good Faith Estimate of Settlement (GFE), which is the rule in California, is too late because the borrower has already applied for a loan. Furthermore, even if early disclosure was feasible, borrowers who don’t understand the process would not be helped.

The Best Remedy Is to Let Borrowers Control Rebates

Fortunately, there is a better rule. It is simple, easily enforceable, and would help the naïve as well as the informed borrower. The rule is that lenders must credit all rebates to borrowers. The borrowers would then have to authorize the payment to brokers. The broker in my previous example, who would like to pocket a 2 point YSP on a 6.50% loan, could no longer do it behind the borrower’s back.

Will HR 3915 Prevent YSP Abuse?

As noted earlier, one of the important objectives of The Mortgage Reform and Anti-Predatory Lending Act of 2007(HR 3915), which passed the House of Representatives November 15, 2007 is to prevent YSPP abuse. Will it?

The first version of the bill that I looked at would indeed have prevented YSP abuse, but it also would have eliminated mortgage brokers. The version passed by the House, modified after inputs were received from brokers, would not put them out of business, but neither would it prevent YSP abuse. Section 123b1 reads as follows:

AMOUNT OF ORIGINATOR COMPENSATION CANNOT VARY BASED ON TERMS- No mortgage originator may receive from any person, and no person may pay to any mortgage originator, directly or indirectly, any incentive compensation, including yield spread premium or any equivalent compensation or gain, that is based on, or varies with, the terms (other than the amount of principal) of any loan that is not a qualified mortgage…

Lets start with the clearest part of this statement, which is the last phrase. Whatever restrictions are called for, they will not apply to qualified mortgages. A qualified mortgage, as defined elsewhere in the bill, is one with an interest rate that is no more than 3% above the comparable Treasury rate, or 1.75% above the average conventional rate.

This indicates that the framers of the bill believe that YSP abuse is a problem only for the highest-rate loans, which is absurd. The problem cuts across the entire market. Indeed, high-rate and high-cost are not the same thing, a loan with a rate only 2% above the average could be loaded with superfluous fees and charges.

Will the restriction on incentive payments at least eliminate YSP abuse on the high-rate loans to which it applies? The bill says that originators (which include loan officers employed by lenders as well as mortgage brokers) cannot be paid more on high-rate loans than on low-rate loans. Since YSP abuse is exactly that, this provision is right on target. It defines YSP abuse accurately, and declares it to be illegal.

Unfortunately, this provision is unenforceable. The standard for determining whether compensation on a high-rate loan is excessive is the compensation received on a low-rate loan, which is unknown and in many cases unknowable. Originators collecting YSP on high-rate loans don’t report what they would have charged on low-rate loans.

To enforce this rule, regulators would have to do a statistical analysis of the originator’s charges on different loans so as to determine whether or not compensation is higher when a loan involves YSP. This is not feasible because there are too many originators and not nearly enough regulators. Even if it were feasible, it won’t work for brokers who get paid only from YSP, which is very common, and it won’t work for loan officers employed by lenders who originate at their own risk, for whom there is no YSP.

Indeed, the only originators who would leave a trail for the enforcement police would be the brokers who give their customers the choice of whether they want to pay the broker out of pocket or have the broker paid with YSP. Because these brokers offer borrowers a choice, fees will be shown with and without YSP, allowing a statistical analysis of whether there are any differences. There won’t be, because these are the good guys. The bad guys will be beyond reach.

In contrast, a rule requiring lenders to credit rebates on high-rate loans to borrowers, who would have to explicitly authorize its payment to the brokers, would impact all brokers alike, and impose no onerous enforcement burden on regulators. Indeed, because wholesale lenders would welcome such a rule, there would be no regulatory burden at all. Poof, YSP abuse would disappear overnight.

To level the playing field between lenders and brokers, a comparable rule is needed that would prohibit loan officers from charging prices above those posted by the lender.

Loan Officer Overages Are an Equivalent Abuse

Loan officers working for lenders also price opportunistically. If they are ignored while brokers are constrained, brokers will move en masse to net branches, a type of entity designed to convert brokers into loan officer employees, while allowing them to operate much as before.

Assume a lender has the same cost of funds as the broker above. If they try to make 2 points, their price on the 6.5% loan would be zero, same as the broker, except that the lender has no YSP to report – its markup is it own business and need not be reported to anyone. Neither a YSP disclosure rule nor the YSP credit rule I proposed above would apply to them.

However, lenders are constrained in their markups because, while some borrowers will pay the high markup, others will shop around and find a better deal. So what many lenders do is price conservatively but give their loan officers the discretion to charge more than the posted prices if they can. These opportunistic price increments are called “overages”, and like YSPs the borrower doesn’t know about them. Curbing YSPs without curbing overages would be a mistake. See What Is a Mortgage Overage?

Overages could be eliminated very easily by the following rule: loan officer employees of lenders must charge the prices posted by the lender.

Some lenders don’t allow overages, and some brokers disclose their fees upfront. Both groups are a minority, because the adoption of consumer-friendly practices is costly when competitors are not obliged to follow suit. Good legislation converts the best practices of the industry into rules for all.